Flying Blind

The murky business of economic forecasting.

July 21, 2010

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1262623_hot_air_balloonSeeking to hobble the inflation beast, the Bank of Canada has raised the overnight rate from historically low levels to … still historically low levels – at 75 basis points. At some point, all that liquidity sloshing around the financial system has to be put into play, normally by bidding up prices on scarce assets. The solution: austerity, whether through higher interest rates or government cutbacks.

That’s the classic horror story. Canada may see a minor replay of the 1990s. But the outlook outside Canada is more dire. A recent exchange between liberal economists Paul Krugman and James Galbraith, with commentary by somewhat Austrian/“austerian” commentator Ed Harrison at the creditwritedowns blog illustrates the murkiness of forecasting.

“It sounds like Krugman is trapped in a gold standard view of money as he assumes the government must issue bonds to fund itself. He forgets that we live in a fiat world and that taxes don’t fund government spending, requiring government to issue bonds for a shortfall. Remember, a fiat currency is one that is created by government. Government can satisfy any commitment in that currency if it so chooses. It could theoretically credit accounts electronically to fulfil its commitment, laws permitting – no bonds necessary…. This is where the austerian in me says “government could simply pay for things with money it prints electronically out of thin air.” You may not like this fact but that’s operationally how fiat currency works. I would argue that this eventually leads to currency revulsion (Krugman talks about using lumps of coal as money) and inflation.

So is inflation about to get out of control (at least in the U.S.)? Not soon, according to the bond markets. James Hamilton at Econbrowser notes the disquieting gap between monetary theory and empirical reality.

“[T]he theory goes, by signaling today an intention of delivering higher inflation rates in the future, the Fed could help stimulate economic activity in the here and now.”

“If that’s your theory, the Fed hasn’t been doing too well by that standard either. The gap between the yield on 5-year nominal Treasuries and Treasury Inflation-Protected Securities has decreased rather than increased compared with the levels before the crisis, and has been declining again recently. According to this measure, the market expects less rather than more inflation.”

The markets are always right?

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